There are some practices that are termed “fatal errors.” This is one of them.
Posted August 10, 2011
The big controvery in the news lately was how to resolve the “debt ceiling” issue. In essence, our legislators were just trying to figure out how much of a loan, as a nation, we could take. As the events of the recent past have taught us, borrowing can be a dangerous game, but when it comes to IRAs, borrowing can be more than just dangerous. It can be a fatal error that can decimate a lifetime of savings.
Sometimes you run across people or companies who are promoting “short-term IRA loans,” but rest assured, these “loans” aren’t really loans. Most of the time, these individuals or companies are simply referring to an IRA owner’s ability to make a 60-day rollover. In theory, you could take a distribution from your IRA, use the proceeds for some extraneous purpose, and then redeposit those funds back into an IRA within 60 days without triggering any income tax. That might sound like a loan, but it’s not. It’s just a rollover and it’s laden with potential problems.
For example, what if you didn’t have the money to put back into your IRA at the end of 60 days? That makes your distribution subject to tax, and if you’re under 59½, you could also get hit with the 10% penalty for early distributions. Plus, you can only make one 60-day rollover from your IRA each year (365 days). If your try and make a second, it’s a fatal mistake and cannot be fixed.
So can you hold a loan as an investment in your IRA? Absolutely. There are only a small group of investments that IRAs are strictly prohibited from investing in, and you won’t find loans anywhere on that list. What is true though, is that you cannot take a loan from your IRA. And for that matter, you can’t use your IRA to make a loan to your husband or wife, son or daughter, or any other person from whom you might receive an indirect benefit as a result of the loan. It’s that last part that can be tricky, since an indirect benefit can come in many forms.
So why can’t you use your IRA to make loans as described above? For the same reason your parents used to tell you that you couldn’t do what you wanted to do, “because I(RS) said so.” Actually, if you really want to be technical about it, you can’t blame the IRS, since it was actually Congress who wrote the law. But the message is the same either way...you can’t do it. If you do, it’s called a prohibited transaction and it comes with a heavy price. If you engage in a prohibited transaction with your IRA—like taking a loan from your own IRA—your entire IRA is treated as if it were distributed on January 1st of the year you engaged in the transaction.
The bottom line is this, if you’re in need of some extra cash, look elsewhere before you dip into your IRA. And if your IRA really is the only place you can tap some needed funds, consider just taking a distribution and paying the tax on it. It’s far better to pay tax on just a single distribution than to engage in a prohibited transaction that would make your entire IRA taxable.
Ed Slott and Company has been called "The Best" source for IRA advice by The Wall Street Journal, and "America's IRA Experts" by Mutual Funds Magazine. Ed is a widely recognized professional speaker and author. Get more IRA information from America's IRA Experts.